The Problem with “Chasing Performance”

Many investors tend to favor funds that have recently done well. This habit is sometimes called “chasing performance” since these investors are constantly trying to get their portfolio to catch up with the results of the top funds. But is it an effective way to invest? That depends on whether funds that have done well in the past are more likely than other funds to do well in the future. And according to a recent study by Vanguard, that’s not the case.

The Vanguard study used simulations based on historical data from 2004 through 2013 to compare two different investing strategies. The first strategy involved selling funds that had underperformed during the past three years and buying funds that had outperformed. The second strategy involved simply holding onto the funds rather than buying and selling based on their recent performance. The study found that the second strategy did substantially better in every fund category that was tested.

The study doesn’t speculate on why chasing performance leads to poor results, but there are a few likely explanations. Funds that have done well may have benefited from a specific short-term trend in the market, such as good performance in a specific sector. If the fund manager’s approach always favors investments in this sector, the fund is bound to underperform once the short-term trend reverses. It’s also possible that the act of chasing performance itself hurts better-performing funds: as more investors shift into these funds, it’s harder for the funds to find good investments to make with all the new money.

The bottom line is that funds that have recently done well often aren’t the same ones that do the best in the future. Frequently buying and selling to replace underperformers with outperformers is a recipe for lower investment returns.